by Jim Welsh
Macro Tides Monthly Report 03 January 2021
Economists are forecasting a strong rebound in 2021 especially in the second half of the year. By the end of 2021 economists expect S&P 500 earnings to climb to $170.00 from $140.00 in 2020 and $161.00 in 2019. Much of this forecast is dependent on the speed of vaccinations and how quickly the American consumer can return to their ‘normal’ spending habits. With the S&P 500 trading above 3700, it is sporting a forward P/E of 22.00 which is the second most expensive level since 1929. Investors are completely onboard assuming that vaccinations will proceed without any meaningful issues and herd immunity will be achieved by mid-year. The stock market is priced for perfection, just as the country may be entering a Perfect COVID-19 Storm in January that may extend well into February.
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COVID-19 Lockdowns Loom in January
In a CNN interview on March 25 Dr. Fauci made this statement which was certainly true then and may also apply to the first half of 2021.
“And you’ve got to understand that you don’t make the timeline, the virus makes the timeline. So you’ve got to respond, in what you see happen. And if you keep seeing this acceleration, it doesn’t matter what you say. One week, two weeks, three weeks — you’ve got to go with what the situation on the ground is.”
Heading into Christmas the situation in the U.S. was bad and deteriorating. Hospitalizations bottomed in late September at 30,000 and proceeded to soar above 125,000, quadrupling in less than 3 months. In some cities the increase exhausted the available ICU beds and by mid-December more than 75% of all ICU beds were occupied.
Thanksgiving played a big role in the surge in hospitalizations as 50.6 million Americans traveled for the Thanksgiving holiday so they could get together with family and friends. In 2020 9.5 million people flew to their destination, which was down -63% from the 26 million people who flew in 2019.
Although the number of people who flew over the Thanksgiving weekend fell significantly, the overall decline was just -8.5% (55.3 vs. 50.6) as 11.8 million more travelers thought it would be safer to travel by car. Increasingly the spread of the virus is not from gatherings at bars, restaurants, and large events, but from small groups of family and friends spending time together indoors.
The virulent spread of COVID-19 just before the holidays couldn’t have occurred at a worse time since more people will be traveling and getting together for the holidays than at Thanksgiving. In 2019, 115 million people traveled for Christmas, with 7 million people choosing to fly. According to AAA an estimated 84 million people are expected to travel in 2020 during the travel window from Wednesday, Dec. 23 to Sunday, Jan. 3, 2021. While that would represent a decline of 27% from 2019, it would be an increase of 60% from the number of travelers for Thanksgiving this year.
There is another surge of hospitalizations coming in the first half of January that may overwhelm hospitals in many cities and force doctors to choose who to treat based on limited medical resources. No doctor or nurse in the United States would have ever imagined they would have to choose which patient would be allowed to die, so another patient with a higher survival probability could receive medical care.
There are going to be many victims of COVID-19 and many will be medical personnel who were scarred from their experience. No one should be surprised if there isn’t a surge of nurses who retire after the emergency of COVID-19 has passed.
In an interview on CNN on December 22 Dr. Fauci expressed concern about the holidays and the risk holiday travel posed:
“As you might imagine, it’s quite concerning to me. This type of travel is risky, particularly if people start congregating when they get to their destination in large crowds, in indoor settings. I’m afraid that if, in fact, we see this happen, we will have a surge that’s superimposed upon the difficult situation we are already in. So, it could be a very difficult January coming up if these things happen.”
The stock market ignored the mounting stress on hospitals in December, prospects for a crippling of the medical system in a large part of the country coming in January, weaker economic data as consumers hunkered down and states implemented more stringent rules to slow the spread. This has been possible for a number of reasons.
Federal Reserve
The Federal Reserve reaffirmed that it will keep the federal funds rates just above 0% for the next few years. The Dot Plot illustrates when each of the 17 members of the FOMC expect the federal funds rate to be increased. Only one member supports an increase in early 2022, while 3 members expect the funds rate to be 0.375% at the end of 2022, with one member projecting the funds rate at 0.625%, and one looking for the funds rate to be 1.125%.
For the long term (whatever that means), every FOMC member thinks the funds rate will eventually reach 2.0% with a majority estimating that the funds rate will top at 2.50% during the current business expansion.
At its December 16 FOMC meeting the FOMC also indicated that it will continue with its current Quantitative Easing program until its long term policy goals are achieved:
“The Federal Reserve will continue to increase its holdings of Treasury securities by at least $80 billion per month and of agency mortgage-backed securities by at least $40 billion per month until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.”
The FOMC provided its quarterly projections for GDP, the Unemployment rate, and PCE and PCE Core inflation for 2021, 2022, 2023, and the Longer Run.
The FOMC thinks the Unemployment rate will be down to 4.2% by the end of 2022, which is why 5 members believe the funds rate should be increased as the FOMC will be close to achieving maximum employment. If the Unemployment falls below 4.0% in 2023, maximum employment will be reached and is why every FOMC supports raising the funds rate by the end of 2023.
On July 17 Fed Chair Jerome Powell made the following comment which summarizes the Fed’s dedication to not only getting inflation to 2.0% but attempting to lift it above 2.0% for a period of time.
“The Fed will not just emphasize actual inflation over forecasted inflation, but will also attempt to push the inflation rate above its 2% target. It’s a whole new ballgame.”
The new ball game officially started on August 27 at the annual Jackson Hole symposium when Powell proclaimed:
“The Committee seeks to achieve inflation that averages 2% over time and therefore judges that, following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.”
The FOMC expects the Personal Consumption Expenditures Index (PCE) of inflation to rise to 2.0% in 2023 and average 2.0% over the Longer Run. These projections indicate that the FOMC doesn’t expect to succeed in getting inflation above 2.0% in the next 3 years, after holding below 2.0% for much of the last decade. This outcome continues a trend that has been in place since 2008. In the 49 quarters since the third quarter of 2008, the Core PCE has been above 2.0% in 3 quarters or just 6.1% of the time.
Although the FOMC may be disheartened by the failure to get inflation above 2.0% since 2008, they should take solace in their success since 1980. From 1775 through the 1970’s the rate of inflation increased and ebbed as periods of inflation were followed by periods of deflation. But since 1980 the cumulative impact of inflation is a sight to behold.
Central Bankers obsession with getting inflation to 2% is mystifying since there is no justification. Central bankers are petrified that deflation will emasculate the effectiveness of monetary policy, especially with debt to GDP ratios so high for every developed country. It is not a coincidence that the surge in inflation since 1980 began just as interest rates peaked in 1981 and continued after the Federal Reserve kept the real federal funds rate below zero percent from 2001 through 2004 and for years after the financial crisis.
This has led to a dramatic increase in government, corporate, and consumer debt in the U.S. funded by exceptionally low interest rates. The increase in federal government debt was driven by Congress with one party being a spendthrift and the other addicted to tax cuts. Debt doesn’t care how it is created only that it be serviced and repaid.
Investors are correct in assuming the Federal Reserve will maintain its accommodative monetary policy through 2021 so no surprises are likely.
Herd Immunity Hurdles
Monetary policy wasn’t the only factor that allowed investors to ignore a deteriorating economy and rising hospitalizations in the last few months. The prospect of a vaccine was given periodic booster shots by Pfizer and Moderna as each reported on the progress they were making during the summer and early fall. Each update provided the stock market a shot in the arm.
On November 9 Pfizer announced that its vaccine was 94% effective which shifted the balance of power within the stock market from the stay at home Mega Cap stocks to cyclical, financial, and small cap stocks. The surge was given a further boost when Moderna followed on November 16 stating that its vaccine was 94.5% effective. The prospect that two vaccines would be available has raised confidence that COVID-19 will be conquered by mid 2021. In this light the increases in deaths and hospitalizations are a terrible speed bump on the way to normal, but a speed bump nonetheless.
There are a number of assumptions in this assessment that may prove overly optimistic. The logistical magnitude of producing, distributing, and vaccinating more than 250 million people (enough to get to herd immunity), not once but twice in a matter of months is daunting. As an Irishman I am well acquainted with Murphy, who like Rust operates 24/7 year round. No holidays and no time off for Murphy, so production delays and difficulty in distributing the vaccine to every part of the U.S. should be expected. Should production and distribution delays occur in January, as the Pandemic sweeps through hospitals, a Mini replay of March could develop in the financial markets.
Delays are already occurring. Operation Warp Speed set a goal of delivering the first dose to 20 million people before the end of December. As of December 31 only 9.5 million doses have been distributed and just 2.7 million have been administered. As the bugs are worked out the rate of distribution will improve and the number of vaccinations will increase, but the first 20 million people won’t have received their first injection until mid January.
Human behavior is another unknown that will play a role in how fast the U.S. is able to achieve herd immunity. Some immunity is provided after the first shot but real immunity isn’t attainable until about a week after each person gets the second shot. Some people will experience some level of discomfort after receiving the first injection and will be reluctant to get the second shot. It was reported that during the Pfizer and Moderna trials that after the second injection more people experienced more pain at the injection site and more reactions. If this pattern is repeated as millions are vaccinated in the next few months, there will be people who elect not to get the second shot or delay receiving it, which could lower the effectiveness of the vaccine.
In the last nine flu seasons the percent of adults getting a flu shot ranged from a low of 38.8% in the 2011-2012 to 45.3% in 2018-2019. Older people (65+) have been much more receptive in getting a flu shot, while only a third of those in the 18 to 49 age group have.
The seriousness of COVID-19 will certainly motivate older people since those over the age of 65 have accounted for 79.0% of all the deaths, with those over 50 adding another 16%. Conversely, those under the age of 34 have only accounted for 1.50% of COVID-19 fatalities, so this group is predisposed to not getting a flu shot and may not feel the need to get vaccinated for COVID-19. This could prove a significant impediment for reaching herd immunity in the U.S.
Unless 75% or more of Americans voluntarily get vaccinated, President Biden may be forced to declare a national emergency and compel everyone to get vaccinated so herd immunity can be reached. If it comes to this there will be many court challenges stating that a mandate to get vaccinated violates some aspect of the constitution.
Eventually it will be the Supreme Court that decides.
The key point is the path to herd immunity will not be a straight line. Any legal challenges to mandatory vaccinations will only provide cover for those who are reluctant or don’t want to get vaccinated and serve to delay when herd immunity is achieved and when the U.S. economy can truly get back to ‘normal’.
The most optimistic projection is that 150 million Americans will be vaccinated by June which is less than half of the 330 million people in the U.S. The most Pessimistic projection is that less than 100 million people will be vaccinated by June.
In an interview with the New York Times on December 23, Dr. Fauci said that the vaccination rate against COVID-19 may have to be as high as 90% to achieve herd immunity:
“We need to have some humility here. We really don’t know what the real number is. I think the real range is somewhere between 70 to 90 percent. But, I’m not going to say 90 percent. When polls said only about half of all Americans would take a vaccine, I was saying herd immunity would take 70 to 75 percent. Then, when newer surveys said 60% or more would take it, I thought, ‘I can nudge this up a bit,’ so I went to 80, 85%.”
If Dr. Fauci is correct and a vaccination rate north of 80% will be required, the odds of that occurring voluntarily are low.
There may be a path to mandatory vaccinations other than the federal or state governments passing a law requiring it. In many parts of the U.S. people have to wear a mask to enter a store and lack of compliance means no service. Private industry is complying with state mandates and some companies instituted mandatory mask wearing before it was mandated by states, i.e. Costco for one.
Compliance for wearing a mask is being enforced by private industry and is not dependent on local law enforcement. For the most part compliance of this new habit has been adopted by consumers. It’s a small step to go from mandating mask wearing to proof of vaccination to enter private businesses where groups of people are shopping. Airlines and cruise ships may be at the vanguard of requiring proof that all passengers have been vaccinated. This would help their businesses improve dramatically as customers feel safer knowing that every passenger had been vaccinated and had immunity.
Once this barrier is broken by the airlines and cruise lines, it won’t take long before movie theaters, sports venues, music concerts, bars, and restaurants embrace the proof of vaccination band wagon. Some people won’t like this and will object but there is a good chance a mandate will be implemented.
In 1905, the U.S. Supreme Court upheld the right of state governments to make smallpox vaccination mandatory to protect the public health, despite common and sometimes severe side effects from the early versions of the vaccine, including skin lesions, muscle aches, fever and fatigue. This will make it easier for the Supreme Court in 2021 to allow states to enforce a vaccine mandate.
The other important unknown is the length of time immunity lasts for those who have contracted COVID-19. A study by the Imperial College London Department of Infectious Disease of 365,000 British people using a home finger REACT-2 test found that antibodies diminished over time. The tests were performed at 12, 18, and 24 weeks. The decline in antibodies was the largest for those over 75 and smallest for those aged 18 to 24. Overall the number of people testing for antibodies fell from 6.0% to 4.4% a decline of 26.5% over six months:
“On the balance of evidence, I would say with what we know for other coronaviruses, it would look as if immunity declines away at the same rate as antibodies decline away, and that this is an indication of waning immunity at the population level.”
A much smaller study of 34 patients between the ages of 21 to 68 by UCLA researchers published in the New England Journal of Medicine last July found that those with a mild case of COVID-19 lost about half of their antibodies after 73 days. This is discouraging since the majority of COVID-19 cases are mild with almost a third of those infected being asymptomatic.
Unless the vaccines stimulate a stronger antibody reaction, it may be possible to contract COVID-19 a second time. If the antibody immunity lasts less than 12 months for the majority of people, everyone would need to be vaccinated again in 2022.
The development of the average new drug can take up to 10 years. Phase 1 lasts for a few months, while Phase 2 can last from several months to 2 years. Phase 3 lasts from one to four years so the long term effects can be determined. Phase 4 can also take up to four years.
Pfizer began working on its COVID-19 vaccine on April 23 and Phase 3 of the trial began on July 27 and lasted about 100 days. The long term side effects can’t be determined in such a short Phase 3 period nor the level of immunity provided. Moderna began work on its vaccine on January 13 and the trial followed a similar trajectory as Pfizer’s. The FDA has pronounced the vaccines from Pfizer and Moderna safe, as noted on the FDA’s website:
“The U.S. Food and Drug Administration (FDA) has granted Emergency Use Authorizations (EUA) for two COVID-19 vaccines which have been shown to be safe and effective as determined by data from the manufacturers and findings from large clinical trials. These data demonstrate that the known and potential benefits of this vaccine outweigh the known and potential harms of becoming infected with the coronavirus disease 2019 (COVID 19).”
While the data collected to date may demonstrate the known benefits of the vaccine outweigh the known harm from becoming infected with COVID-19, the fact is the amount of data collected is a fraction of what is accumulated during a trial that normally lasts 6 to 10 years. No wonder then that, despite the assurances by the FDA, a significant number of medical personnel are reluctant to be vaccinated. A CDC survey of nurses in October found that only 34% would voluntarily receive the vaccine if not required.
A late October survey of 13,000 nurses by the American Nurses Association found that one-third of them said they would voluntarily take a vaccine, another third said they wouldn’t, and the rest said they were unsure.
Comments by a nurse at the Henry Ford Health System likely sums up what many nurses think about the COVID-19 vaccines:
“I will decline to take the vaccine. It might cure COVID for now, but what are the side effects down the line? It was produced so fast. If it was out a little bit longer, and more research was done on it, I’d probably take the vaccine, just like the flu shot or any other vaccine. But because it came out so fast, it’s just not something that I trust. The nursing staff feels as though they don’t want to be somebody’s science experiment, or a guinea pig.”
According to the Pew Research Center many Americans feel just like the nurses. In a November poll after the vaccines were approved by the FDA, a majority of people said they would be uncomfortable being among the first to get vaccinated, with 39% saying they would not get vaccinated in part due to the record shattering speed of the vaccines’ development.
Many view vaccination as a magic bullet that will stem the spread of the virus once a majority of Americans are vaccinated since those who are vaccinated can no longer infect others. This seems a reasonable assumption but the fact is no one knows if this is true. The new vaccines were determined to be 95% effective in developing antibodies and providing at least short term protection from COVID-19 for those vaccinated, but the trials couldn’t prove whether they also prevent transmission.
It may be possible for a vaccinated person to become infected again but not show any symptoms since their immune system was fortified by the vaccine. But the vaccination wouldn’t stop them from infecting others. This may be why Dr. Fauci is suggesting 90% of the population may have to be vaccinated since secondary asymptomatic transmission is possible until proven otherwise.
Proving vaccinated people are not capable of transmitting the virus would require a human challenge study in which 50 young adults would be vaccinated and 50 would receive a placebo. All 100 participants would be deliberately infected with the COVID-19 virus. If the vaccinated participants don’t show any or very little shedding of the virus in the following two weeks, there would be strong evidence that the vaccine prevents subsequent spreading by those who have been vaccinated.
But, as infectious disease researcher Joshua Schiffer at the Fred Hutchinson Cancer Research Center explained:
“While I do think that a human challenge study would provide the answer, the ethics of this approach are complex and require significant debate among experts in the field.”
This suggests the answer may not be forthcoming for some time. Until this transmission issue is resolved and known, mandatory mask wearing and social distancing will be necessary for even those who have been vaccinated.
On December 29 Colorado confirmed that a man in his 20’s was the first confirmed American who has contracted the COVID-19 variant found in Britain known as B.1.1.7. The World Health Organization has stated that the new strain isn’t more dangerous or more deadly than COVID19, and Pfizer and Moderna have stated they believe their vaccines will prove effective against the new strain.
While this is good news (if true), the near term risk is that it spreads 50% to 70% faster than COVID-19, which could absolutely exhaust already stretched medical resources throughout the U.S. in coming weeks.
High Expectations
Economists are forecasting a strong rebound in 2021 especially in the second half of the year. By the end of 2021 economists expect S&P 500 earnings to climb to $170.00 from $140.00 in 2020 and $161.00 in 2019. Much of this forecast is dependent on the speed of vaccinations and how quickly the American consumer can return to their ‘normal’ spending habits. With the S&P 500 trading above 3700 it is sporting a forward P/E of 22.00 which is the second most expensive level since 1929.
Investors are completely onboard assuming that vaccinations will proceed without any meaningful issues and herd immunity will be achieved by mid-year. The stock market is priced for perfection, just as the country may be entering a Perfect COVID-19 Storm in January that may extend well into February.
Dollar Detour Coming
After peaking on March 23 (same day the S&P 500 bottomed), the Dollar has declined -12.6%, which has provided a tailwind for risk assets. There are a number of consensus trades going into 2021 predicated on additional weakness in the Dollar that is expected to boost small cap stocks, Emerging market equities, Gold and commodities in general. Those who are bearish the Dollar expect it to fall below the February 2018 low of 88.25 and weaken substantially after breaking this important level of support. There are a number of reasons why the Dollar is not likely to break below 88.25.
After peaking in January 2017, the Dollar bottomed in mid-September at 91.01 (wave 3) after experiencing a protracted -12.3% decline. The Dollar then bounced until the first week of November (wave 4) before dropping to a new low at 88.25 in February 2018 (wave 5). The Dollar’s RSI at the September 2017 low was 23.4 but was 25.8 when the Dollar recorded a lower low in February 2018. This positive divergence was a strong indication that the Dollar was poised for a rally in addition to the completion of 5 waves down from the January 2017 high.
The Dollar is following a similar path in 2020. After topping on March 23 the Dollar experienced a persistent -12.6% decline before posting a low on August 31 (wave 3). After bouncing (wave 4), the Dollar has dropped to a new low but its RSI has so far recorded a positive divergence. (29.4 August versus 32.4 on December 30) The Dollar appears to be close to completing 5 waves down from the March 2020 peak which indicates that a rally to at least 95.00 is coming. In 2017 the Dollar spent 5 months finishing wave (4) and wave (5). The Dollar hit the low for wave (3) on August 31, and if wave (4) and wave (5) takes 5 months, the Dollar would be expected to bottom at the end of January.
While the Dollar may take another month or so to complete the bottoming process, chart and technical analysis suggests a low is near.
It is common for sentiment and positioning to reach an extreme after a security has been trending for an extended period of time. In the Net USD Positioning chart you can see how Noncommercial traders, Asset Managers, and Leveraged Funds became progressive less bullish and then more bearish as the Dollar declined during 2017 after topping in January 2017.
The same pattern has been repeated in 2020, except the positioning is more extreme now than in 2017- early 2018. The Commercial’s Net Position was short as the Dollar topped in 2017 and switched to a net long position in early 2018 just before the Dollar rallied. The same pattern has emerged in 2020, but the Commercial’s now have a larger net long position than in 2018.
The Euro represents 57.3% of Dollar so it exerts more leverage on the Dollar than any other currency. As the Dollar was topping in 2017 the Euro Positioning Indicator was -70, which suggested the Euro was about to rally and the Dollar would therefore decline. As the Dollar was bottoming in February 2018, the Euro Positioning Indicator was above +40 and the highest level since 2013. The Euro subsequently fell and the Dollar rallied. In March the Euro Positioning Indicator was -60 suggesting the Euro was poised for a big rally and a decline in the Dollar.
The Euro Positioning Indicator is above +60 and the highest level in the past 8 years, which suggests that the Euro is ripe for a correction that will boost the Dollar.
The Euro has rallied +15.6% since bottoming on March 23 through December 30. A stronger currency makes European exports more expensive and increases deflationary pressures. This is neither good for economic growth or making progress towards the ECB’s goal of getting inflation up to 2.0%. There is a good chance that in the first half of 2021 ECB president Christine Lagarde will express concern about the Euro’s strength, which would give currency traders a strong signal to sell the Euro and potentially short the Euro.
In recent months investors ignored the health and economic threat from the third surge in the COVID-19 Pandemic, focusing instead on the Federal Reserve’s accommodative monetary policy, the prospects for a smooth vaccination process that achieves herd immunity by mid 2021, and continued weakness in the Dollar in 2021. The Federal Reserve is going to maintain its accommodation throughout 2021, but the road to herd immunity is likely to prove more challenging than expected, and the Dollar is going to rally with the only question being how much.
If the vaccination process proceeds more slowly than expected and the Dollar rallies even 5%, two of the pillars that have girded investors from acknowledging the obvious health and economic risks will be less sturdy in the first quarter.
Stocks
The Federal Reserve’s extraordinary monetary accommodation and negative real interest rate policy coupled with unprecedented fiscal stimulus has created a one-way mentality for call option traders and stock investors in the extreme. Whether it is called a Mania or a Bubble doesn’t matter to those who believe monetary policy is a form of immunization from any negative news. As long as momentum remains positive, this ‘investment strategy’ will continue to work.
Measures of valuation are like the GPS in our car or phone. They tell us where we are but also where we’re headed. The 15 different valuation metrics in the table confirm that the stock market is overvalued, just as does the S&P 500’s Forward P/E.
Valuation metrics are a poor timing mechanism for the coming six months but have been a good predictor of future returns in coming years. Figure 13 is based on the Stock Market’s Capitalization to GDP (#2 in the table) and has provided an excellent GPS for the expected returns from the S&P 500 over the next 10 years.
Based on the market’s current valuation the expected average return for the S&P 500 in next 10 years is -6.0%. Given the market’s current valuation, it’s not if but when the S&P 500 declines by -40% to -50%. If you’re an investor who relies primarily on a buy-and-hold investment strategy, consider adding a tactical investment strategy for a portion of your equity assets. (We do this at Smart Portfolios.)
If the Pandemic overwhelms medical resources in many cities in coming weeks, and more stringent lockdowns are implemented, the S&P 500 has the potential of correcting -10% to -15% early in 2021. As hospitalizations peak and the rate of vaccinations ramps up, potentially aided by a vaccination mandate, the S&P 500 is expected to rally above 4000 in the first half of 2021.
The stock market has recorded a significant low every 20 years going back to 1903, after experiencing a major decline. In 2022 the 20 year cycle and 40 year cycle project another important low similar to what occurred in 1942 and 1982.
The interesting aspect of these cyclical declines is the reasons for them have been different. The DJ Industrials lost -40% of its value after topping in September 1901 and bottoming in November 1903 at 42.15. The “Rich Man’s Panic” in 1903 was caused by a number of factors including an anti-trust suit against the Northern Securities Company, which combined three large railroads and was owned by E.H. Harriman, J.P. Morgan, and James Hill.
The DJ Industrials rallied during the 1918-1919 Flu Pandemic rising from 75.00 to 120.00 in late 1919. In January 1920 the U.S. slipped into a post World War I deflationary depression as wholesale prices fell by -36%. The DJ Industrials fell -46.6% before bottoming on August 24, 1921 at 63.90.
After peaking at 157.00 in August 1939 the DJ Industrials began a long slide as World War II began in September 1939 and didn’t find a bottom until it fell to 92 in April 1942 after losing -41.4%. The tide turned in early May 1942 when the U.S. won a decisive naval battle against Japan in the Battle of Coral Sea, as depicted in the movie Midway.
In 1962 President Kennedy assailed U.S. Steel for raising prices after assuring him they wouldn’t. After peaking in November 1961 at 72.00 the DJ Industrials dropped to 53 in June 1962 (-26.4%), with the bulk of the drop (68 to 53) occurring after President Kennedy held a press conference on April 11, 1962.
The low in 1982 formed after the DJ Industrials had traded sideways for 16 years ending the secular bear market. The low in 2002 occurred after the dot.com bubble burst and the S&P 500 lost -49.7%.
In the last week of December 2020, the Advance – Decline lines for the NYSE and Nasdaq have continued to make new highs, and 90% of stocks on the NYSE are above their 200 day average. This is indicative of strong market breadth, which normally weakens before a top of consequence, and is why the S&P 500 is likely to rally to a higher high after any near term correction.
There are many indications that speculation has ramped higher in recent months and I won’t list them all, but the increase in Margin Debt is notable. Since January 2020 Margin Debt has jumped from $561 billion to $722 billion in November, an increase of 28.7%, and is up 50.7% since the low of $479 billion in March.
In the last 32 years an increase of this magnitude in 8 months has only occurred twice – just before the top in 2000 and in 2007. Margin Debt rose by more than 50% from a low in March 1999 into January 2000, just two months before the S&P 500 and Nasdaq 100 topped ending the dot.com bubble. From a low in October 2006, Margin Debt rose by more than 50% into July 2007, just three months before the S&P 500 peaked.
Margin Debt didn’t peak until February 2008, while the peak in March 2000 coincided with the peak in prices. This suggests the stock market could make an important high within the next six months.
Consensus Trades – Small Cap Stocks
The Bank of America monthly Fund Manager Survey (FMS) polls a broad section of money managers to quantify how they are positioning their portfolios. The recent survey revealed a number of consensus trades based on their economic outlook. Fund managers believe the economy will grow smartly in 2021 as the vaccines and fiscal stimulus work their magic.
Small cap stocks are expected to outperform large cap stocks handily by a record net of 31%. Other than for a brief period after the 2016 election, the fund managers in the FMS survey consistently expected small cap stocks to underperform large cap stocks since 2006.
The Russell 2000 small cap index just experienced its best monthly gain in history in November. Even if these managers prove prescient in their long term outlook, the current price level doesn’t look particularly attractive. The Russell 2000 has rallied up to a trend line that connects the high in early 2014 and the peak in August 2018. After the early 2014 high, the Russell 2000 spent the next two years chopping sideways before ultimately falling more than -22% below the 2014 high when it bottomed in February 2016. After the peak in August 2018 the Russell 2000 subsequently lost -44% of its value when it bottomed in March 2020.
The initial rally from the March low of 966 carried to Russell 2000 up to 1537 on June 8, which was the first high in the rotation and reopening trade. An equal rally (1537-966=571) from the September low of 1433 would project a high of 2004. The March 2020 low was 301 points below the December 2018 low, and when added to the August high of 1742, would project a high at 2043.
The Russell 2000’s high on December 28 was 2026 which is almost in the middle of the two projections. The rally since the September low is only three waves, suggesting the Russell 2000 is likely exceed 2026 in wave 5. If the stock market corrects -10% to -15% early in 2021 and the Russell 200 drops below 1800 and ideally close to 1750, it may offer a good risk reward for a rally above 2026 in the first half of 2021.
Consensus Trades – Emerging Markets
Fund managers in the Bank of America FMS are in love with Emerging Market Equities. A whopping 44% are Overweight Global Emerging Market stocks, which is the highest percent since November 2010. The relative performance of EM stocks topped within 5 months after November 2010 and proceeded to fall continuously until early 2016. After a brief bounce into early 2018 the relative performance fell into the summer of 2020. After such a lengthy period of underperforming, Emerging Markets are certainly due for a better run. But the price point at which EEM is trading now is not attractive, at least in the short term.
After fund managers were comparably overweight in November 2010, the Emerging Market ETF (EEM) rose another 6% to 8% before peaking in April/May 2011, so there may be a bit more upside. (Chart below) However, EEM is approaching a trend line connecting the May 2011 high ($50.12) and the January 2018 top at $51.77. In November EEM broke out above the black trend line which connects 4 prior highs near $46.50. This prior level of resistance could become support. If the S&P 500 corrects 10% or more in early 2021, EEM is likely to pull back to the black trend line just above $46.50 and offer a lower risk entry point than current prices. EEM could test the 2007 high at $55.49 in the first half of 2021.
There are two fundamental headwinds that could materialize in 2021. One of the reasons so many fund managers like EM equities is their expectation that the Dollar will decline more in 2021. As discussed the Dollar is poised for a rally, which may cause EEM to correct down to $46.50.
The second fundamental reason has to do with the distribution of the vaccines, which will more difficult in many EM countries. The U.S. is likely to experience some speed bumps as it attempts to vaccinate upwards of 300 million people. The challenge of vaccinating a large population in emerging economies is even more daunting and difficulties may prove a drag on growth in some emerging economies as the Pandemic persists requiring more lockdowns.
Consensus Trades – Commodities
With the majority of investors expecting additional weakness in the Dollar and a significant rebound in the global economy in 2021, commodities are expected to benefit. Some of this optimism is built on the performances in many commodities in 2020. The housing market has been strong in the U.S. and lumber prices soared by 141.1%. The global recovery story boosted oil prices with WTI gaining 106.6%. Industrial metal prices – copper +63.0%, Nickel +53.0%, and Aluminum +28.2% – were bid up in expectation of much higher demand in 2021.
Past isn’t always prologue so some of these markets could be vulnerable if the U.S. and global economy stumble in early 2021.
In the FMS survey the current allocation to commodities is the highest since April 2011, which coincided with a major peak in commodities. The Bloomberg Commodity Index subsequently dropped -63.3% from the high in April 2011, until it recorded the low for blue Wave (3) in February 2016. The weekly RSI (red arrows) is near 70, which has been reached at every high of consequence since 2011. It is possible that the Commodity Index may perform as it did leading up to the high in April 2011. The weekly RSI initially topped above 70 in November 2010, and then moved above and below 70 as the Commodity Index pushed higher for another 5 months.
At the low in March 2020, the Bloomberg Commodity Index appears to have completed 5 waves down from the April 2011 peak blue (5). This suggests the Index should rally for more time and push higher and at least attack the purple trend line and high for (red) wave e of (blue) Wave (4) at $23.10. There is a lower probability that the Index could trade up to the June 2018 of $25.80 wave c of wave (4).
If the markets experience a quick swoon in early 2021 and commodities weaken too, the Bloomberg Commodity Index ETF (DJP) could decline to $21.03 – $21.30. A pullback would alleviate how overbought DJP has become and provide a better entry price for a subsequent rally to $23.10 or $25.80 in the first half of 2021.
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